J.P. Morgan Pays $13 Billion in Fines: Is it enough?

The drawn-out aftermath of the 2008 financial crisis now allows Americans to attach concrete figures to the amorphous responsibility that financial institutions had in creating it.

The lengthy litigation process that followed the financial crisis is slowly winding down, and some Wall Street banks are finding themselves on the hook for enormous sums. On October 25, news of a preliminary $13 billion settlement between the Department of Justice (DOJ) and J.P. Morgan broke into wide circulation. The settlement was finalized and announced by the Department of Justice on November 19, despite outcry about J.P. Morgan’s ability to deduct most of this sum from its tax bill. Such a large figure finally allows the public to translate vague accusations such as “reckless risk taking” and “greedy behavior” into real numbers.

As legal settlements like this one continue to trickle in, an obvious question emerges: Are these fines large enough?

This question first requires a discussion of the raw amount. On the one hand, $13 billion is certainly huge compared to historical figures. According to its financial statements, J.P. Morgan’s litigation expenses were a fraction of this fine in the years immediately preceding the financial crisis, not rising above $3.7 billion in 2004. Even by financial crisis standards, this settlement contains the largest fine ever paid by any one bank thus far, eclipsing a closely-related $25 billion settlement that five large banks reached with the DOJ and 49 states in 2011. J.P. Morgan has set aside some $23 billion in litigation reserves, a sum larger than the value of most companies traded in the U.S. stock market.

Given its sheer magnitude, the $13 billion fine is probably meaningful enough to figure into how banking executives make decisions about investments and business practices. In fact, J.P. Morgan has probably made these changes already.

But the bigger picture is that fines are backwards-looking devices of discipline. They are effective in preventing people from repeating known bad actions. They are not effective at preventing people from engaging in actions that no one knows will be end up badly.

Financial crises start from product innovations that are perceived to be so beneficial that they are adopted by the whole market. It’s hard to believe now, but the complicated financial instruments that were at the center of the 2008 crisis were once considered to be important innovations. Subprime loans were considered an innovation that gave opportunities for millions of people to become homeowners. Mortgage-backed Securities (MBSs) allowed mortgage originators to bundle many mortgages together and sell them in the open market, and in the process getting more capital to make more loans to more and more potential homebuyers. This was a positive development, as the U.S. government has tried to expand homeownership for decades.

These products had clear benefits, which is why market participants adopted them. Over the years, of course, many of these products turned out to be lousy investments, in no small part because they were used irresponsibly. The losses in turn propagated into the rest of the economy and resulted in a financial crisis. (It’s like, for example, the invention of cigarettes or the incorporation of asbestos into construction. No one knew the health hazards in the beginning, and the hedonic and economic benefits of those innovations were obvious from the outset.)

The causes of future financial crises are unlikely to be similar to the causes of the previous one. Fining J.P. Morgan on activities such as “robo-signing” or selling dubious securities to clients may reduce the frequency of this behavior, but this particular behavior may not be relevant in the future.

The benefit of hindsight also makes it easy to forget that during the inception of the crisis, bankers followed a playbook of “best practices” regarding how to properly deal subprime loans and MBSs. As the financial crisis progressed, this playbook changed. “Robo-signing” stopped being efficient and became criminal negligence. Selling risky bundles of mortgages to investors stopped serving clients and became an example of greed.

No one knows yet what will be the great financial innovation of the future. It could come from anywhere: a small trading firm, a large bank, a hedge fund. And no one knows whether these yet unknown innovations would end up turning sour as the MBSs that led to the 2008 crisis have. It is difficult to know what uses of these innovative products would be considered inappropriate ahead of time. Most financial innovations, like the index fund, IRAs, or Social Security, do not end up causing crises. Big fines for the banks’ big mistakes are morally justified, but the very desire to innovate also fuels the headstrong behavior on the part of the innovators that at first might create significant value and boost adoption and later might be considered as “reckless.”